How to take full advantage of franking credits

It’s important to gain a solid understanding of franking credits (or imputation credits) and how they work, as they can be most advantageous to an investor’s returns (particularly for super funds).

In summary, franking credits are attached to the dividends paid by some Australian companies. Dividends can be franked or unfranked, with a franked dividend being a dividend on which company tax has already been paid.

Franking was introduced in Australia in 1987. Prior to that, profits made by a company were taxed at the company level and then, when paid out as dividends to shareholders, they were taxed again in the hands of those shareholders. Two sets of taxes on the same profits… good for the government, not good for you! But under the current system, investors who receive franked dividends are entitled to a credit for the amount of tax already paid by the company. This credit reduces the amount of tax to be paid by the investor. In simple terms, the shareholder is allowed to claim the imputation credit as a tax rebate.

As the corporate tax rate in Australia is 30%, this means that TLS has already paid 30% tax and the 28c that the investor receives is post tax.

So how do we work out the pre tax amount, or the gross dividend? We simply say that if 30% tax has been paid, then the 28c we receive is equal to 70% of the gross dividend. And what is 28c 70% of? 28 divided by 0.7 equals 40c. So TLS pays 40c in gross dividends per annum.

And the amount paid in tax by TLS (or franking credit) is obviously 40c minus 28c, which equals 12c. So if one owns 10,000 TLS shares, this means that the dollar value of the franking credit is 10,000 multiplied by 12c, which equals $1200. This amount can be offset against one’s taxable income to effectively reduce tax payable.

Let’s look at an example that compares the current franking system to the classical system that existed prior to 1987. For this example, let’s assume a personal tax rate of 30%, and we will take the corporate tax rate of 30%. With the pre-1987 system, if listed company XYZ earns $1000, it is taxed $300, leaving it with $700 in post tax earnings. If this $700 is paid as a dividend to an investor, the investor pays $210 in tax (30%) on this dividend. This leaves $490 as the after tax dividend. So, only $490 of the original $1000 in earnings winds up in the investor’s pocket after all tax is paid.

Under the current franking system, if company XYZ earns $1000, it is taxed $300, leaving it with $700 in post tax earnings. The investor now receives the $700 as a dividend (as before), but also receives $300 worth of franking credits (the amount already paid in tax by the company). When calculating the amount of tax that must be paid by the investor, it is calculated on the gross value of the dividend, which is the cash value of the dividend ($700) plus the value of the franking credits ($300). This gross value is $1000, and so the investor on a personal tax rate of 30% is taxed $300. So the investor has a tax liability of $300, but franking credits of $300 too. These franking credits offset the tax owed, meaning that in this case, no tax is owed. Therefore, the after tax dividend to the investor is $700… much better than the $490 received under the old system!

But where things get really interesting is for vehicles paying less than 30% tax, such as superannuation funds. People often wonder how they can better diversify their superannuation, or how they can derive greater benefits from the tax structure of super funds. Well, franking credits are one such way. And so setting up a self-managed super fund (SMSF) and investing in companies paying high fully-franked dividends makes sense.

To use the above example, but for a super fund paying 15% tax, not an investor paying 30% tax, consider the following. So company XYZ earns $1000, it is taxed $300, leaving it with $700 in post tax earnings. The super fund now receives the $700 as a dividend (as before), but also receives $300 worth of franking credits (the amount already paid in tax by the company). As mentioned, the amount of tax that must be paid by the super fund is calculated on the gross value of the dividend, which is the cash value of the dividend ($700) plus the value of the franking credits ($300). This gross value is $1000, and so the super fund on a tax rate of 15% is taxed $150. So the fund has a tax liability of $150, but franking credits of $300 too. These franking credits offset the tax owed, and then some. Not only is no tax owed, but the super fund gets a $150 tax rebate! So the super fund winds up with $850 of the original $1000 in earnings.

Franking credits are so attractive that there is a condition surrounding the benefits they confer on investors. If you have less than $5000 of franking credits annually, then you need only hold the stock for one day if you choose and you still receive the franking credits. However, should you have more than $5000 in franking credits over the course of the year, you must hold the shares for at least 45 days to claim the franking credits on dividends received. Learn how the 45-day holding rule works here.

At Rivkin, we have designed a number of blue chip portfolios that pay very solid, fully-franked dividends. These portfolios are issued every quarter, and investors need only take up one of them and then rebalance once a year. This is an incredibly low maintenance, low risk strategy, offering particular benefits for low tax paying vehicles such as super funds, on account of their franked dividends. You can take a trial on this advice service, Rivkin Local, here.

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